As evidence-based investors, Claris and our clients follow decades of Nobel Prize-winning research and tilt investment portfolios toward long-term sources of higher expected returns. These sources, or premiums, were conclusively identified by the groundbreaking Fama/French three-factor asset pricing model. More recent updates have added two factors to this model, but that’s a topic for another time. The three-factor model shows that differences in investment returns can almost entirely be attributed to the following premiums:
- Equity: Stocks have returned more than bonds.
- Small-cap: Small company stocks have returned more than large-company stocks.
- Value: Value company stocks have returned more than growth company stocks.
To single out the value premium, data shows that from 1927 through 2017, value stocks outperformed growth stocks by 4.8% per year. While the existence of the value premium is no secret, it is also no secret that it has been hiding for quite a while. In U.S. markets, value has underperformed growth over the last 10-year period, leading some to question its viability.
Reacting to Underperformance
Considering this recent underperformance, what is an investor to do? Although disappointing, this type of underperformance is not unprecedented nor unexpected. In fact, since the late 1970s, 27% of all rolling 10-year periods have seen a negative value premium. Of course, on the flip side, this means 73% of the periods have seen a positive premium. It is important to remember that if the value premium was positive every year, it would quickly be taken advantage of and priced out of existence. The positive side of the premium is the reward an investor reaps for sticking out the tough times, much like the stock market in general.
While there is no guarantee of future out-performance, let’s cast a hopeful eye at the last 10-year period where growth stocks outperformed value. For the decade ending October 2000, growth bested value by 2.1% annually, causing some to question whether the value premium had disappeared. Suddenly, the tables turned and value bested growth by 35% over the next five months. Based largely on this unpredictable surge, value ended up outperforming growth at a 2.4% average annual clip for the 10-year period ending May 2001.
In short, the preponderance of peer-reviewed, academic evidence shows we have every reason to expect the value premium to show up again. Unfortunately, no one knows exactly when this will be. To answer our earlier question, the best course of action for an evidence-based investor is to stick with the evidence, tolerate the underperformance, and remain well-positioned to secure the unpredictably timed rewards.